Category Archives: 100 Ways to Beat the Market

On occasion, Mohnish Pabrai has told a story he learned from management guru Tom Peters about imitation. Apparently there were two gas stations on the same corner. Each propriator could clearly see what the other was doing. One of them began building his business by extending full service to some, but not all, of his customers. The rival concluded that this wouldn’t work and refused to copy the practice even as he saw his competitor take away business.

The lesson: imitating smart practices works and – equally important – many, if not most, people fail to practice intelligent imitation, even in the face of evidence that it works (better than what they are currently doing). Mohnish practices what he preaches and has built a successful money management business largely – by his own admission – on imitating the practices of Warren Buffett and Charlie Munger.

At a recent talk he gave (via Skype) at the Ivey School of Business in Ontario, Mohnish spoke of the value of only making an investment if the stock is already owned by a successful value investor such as Warren Buffett or Prem Watsa. (Buffett himself benefited from cloning, for example, getting involved in GEICO when he learned that Graham was on the board.)

Mohnish compares this to only bowling with the bumpers up. He argues that you will make fewer mistakes than going it alone.

This is excellent advice. These great investors have enormous experience and are backing their ideas with serious capital, much of it their own. Mohnish goes on to argue that you could be successful by being a blind follower, but that few are willing to do this. He may very well be correct.

Nevertheless, I believe it makes sense to only invest when you understand a given investment. The issue is one of human behavior. It can be hard enough to stay with a position through periods of extreme volatility; this is doubly difficult if you don’t have conviction borne of your own understanding, particularly if you are a focused investor.

If you want to beat the market, one very intelligent thing to do is to limit your investments to those that are owned by a great value investor with a long-term proven track record. The market affords no style points for being innovative and creative. Money is earned by being right.

How many times have great value investors affirmed the wisdom – and profitability – of this simple advice: average down when buying and average up when selling. How few – even those who understand its inherent logic – fail to do so on a consistent basis. It takes enormous discipline to not take a valuation cue from price action. Yet this is precisely what the great ones do not do – they take their cue from a dispassionate, margin-of-safety-infused estimate of intrinsic value. Without this practice, the Mr. Market parable is of little use, reduced to a quaint anecdote of Buffett’s mentor, Ben Graham.

Gurufocus has a nice feature where you can see both graphically and in tabular form the historic equity purchases of prominent value investors. How often have I observed that the best, focused value investors frequently buy more – sometimes much more – when a newly established position craters down in price. Conversely, I have frequently seen the same investors average up by selling a portion of their shares if Mr. Market makes a particularly tantalizing offer. This can result in a staggering IRR on the sold portion and greatly reduce the risk of capital loss on the remaining shares as they are held for greater gains.

In his recently published 2012 letter to Fairfax Financial shareholders, Prem Watsa – a preeminent practitioner of value investing who has grown book value by over 23% per year over 25 years and generated a 14% annual return on common stock purchases over the past 15 years – recounts how Fairfax Financial generated a realized gain of $341 million from International Coal using precisely this technique. (Prem lays it all out in tabular form). After initiating a position at $4.58 per share, they averaged down, bringing their average cost down to $3.37 per share. They subsequently sold half their position for a gain of 115% at $7.26 per share. The remaining shares were sold only five months later when there was a takeover offer for the company at double that price. (Fairfax sold at $14.60 per share.)

This was done without buying at the low or having any special ability to see into the future. All that was required was the right intellectual framework and emotional discipline. Watsa relates how he has been using exactly the same investing technique for the past 35 years.

Incorporate the same approach into your investing process and you will greatly increase your odds of beating the market.

At its core, investing is about putting out money now to get more in inflation-adjusted dollars in the future. To be done intelligently, this requires you to be able to predict with meaningful accuracy the future economic development of a business. If you cannot do this, it is impossible to handicap the odds and make a rational calculation of the odds of loss times the amount of the possible loss versus the odds of a payoff times the amount of that payoff (the essence of rational investing).

The right framework – and arguably the most important question – is thinking about where the business will be in ten years. It challenges you – if you are honest with yourself – to decide if you really understand the business. For some reason, this is more of an issue with buying stocks than buying an actual business. A buyer of a private business naturally thinks about where the business will be in ten years – perhaps because he intuitively knows that there will be no greater fools around to buy his stock at a higher price. His fate will be entirely determined by the economic performance of the business. The irony here is that the same applies when buying a stock. It is just that so many have been impacted by the faulty thinking so prevalent on Wall Street, which tends to view stocks as lottery tickets rather than pieces of a business.

Thinking about where a business will be in ten years gives you an edge because so many of your competitors are focused on the short term. If they don’t get the short term right, there will be no long term they reason, so they stick close to the herd where they can find refuge in mediocre relative performance.

Thinking about where a business will be in ten years is a powerful filter that will save you research time because it allows you to quickly eliminate businesses where it is impossible to determine (not necessarily impossible per se, but for you, which is all that matters). Generally speaking, change is the most common reason that makes it impossible to judge where a business will be in ten years: rapid technological changes, no moats with competitors flooding in, decaying business models, and creative destruction are all common contributing factors.

As Buffett is fond to stress, it does not matter if the number of businesses you can predict is small. Fortunes have been made concentrating in one business that is deeply understood. Think Rose Blumkin. Put a premium on certainty, even if it means giving up some potential return. Compounding is the wealth engine, and many have disrupted its magic by overreaching. If you are more or less certain that you have a good understanding of where the business will be in ten years and you wait for a price that allows you to meet your hurdle rate, the odds will favor you beating the market.

Value investing is seemingly more popular than ever. Books on value investing continue to multiply. Several universities offer programs based on the principles of value investing, and a number of MBA programs send their students on pilgrimages to Omaha to meet with Warren Buffett. These schools produce many trained specialists who find work in various value-oriented hedge funds and money management firms. The web is full of various sites and blogs – like this one – that follow a value investing philosophy.

It is impossible to assess the collective fruit of all these efforts. It is, unfortunately, very possible to be well versed in value-investing methodologies and still fail to produce above-average results.

One thing that can lead to sub-optimal results is under appreciating how efficient the market is most of the time. Wall Street is full of a lot of smart people who dedicate tremendous energy to following the market. The Internet has only made it easier to stay on top of the latest news and information. It is wise to recognize this reality and remain very humble about being able to gain an edge on the basis of better research alone.

In spite of these highly transparent markets and trained professionals, the short comings of human nature are still occasionally on full display, in the form of multitudinous frailties, overreactions and misjudgments. You absolutely want to look for these periodic occasions when the person on the other side of the trade is acting in a way that is irrational.

This is precisely why the Mr. Market parable is so central to value investing. As Bruce Greenwald put it in an interview with The Motley Fool, “Graham saw was that the best indicator of irrationality – sort of a systematic, statistical indicator of irrationality on the other side – is when things get oversold.”

Exploiting this is not so much about having an information edge over the other guy – although you must thoroughly do your homework – as much as it is having an edge in temperament. That is why your search strategy should focus on spotting situations where securities are clearly oversold and sellers are acting irrationally.

Most of the time these are unavailable, but, when they are, you must pounce. These are where the big money is made and where the true, professional value investors, who consistently beat the market, operate.

One of human beings’ quirks is that we are attracted to action. We want something to always be going on. My kids will come to me and say, “I’m bored.” It is not a state they like, and they want me to fix it by conjuring up some exciting activity on the spot.

Thinking about your investing process is not all that attractive to most investors. It seems boring. “Forget process. Just point me in the direction of the next ten-bagger and I’ll be happy.”

Regardless of how we see the world, truth has a way of imposing itself. And the truth is that process is boring, but it is where you can arguably make the most progress as an investor, if you relentlessly focus on it. Over time you will get better, and your results will improve.

Buffett has rightly said that what an investor needs to be successful is a rational framework and the right temperament. He’s correct, of course. But too many stop there and spend, perhaps, too much time thinking about their investment philosophy and not enough time on their process.

Here are some questions that can help you improve your process:

1. How do you search for new ideas?

2. Is your search strategy robust, i.e. does it reasonably insure that you will not miss attractive investments within your circle of competence?

3. How often do you run your screens? Are you consistent?

4. Do you have preliminary filters in place – required hurdle rate, risk profile, complexity, un-knowability, etc. – to quickly weed out ideas and not waste precious research time?

5. When you do find an idea, do you have a well-defined research process or checklist that you go through, without exceptions?

6. Have you carefully defined your valuation methodology? How could you improve it? Do you have a required hurdle rate, and is it appropriate?

7. Do you have investment checklists to help determine if a business is good and if management is a worthy steward of your capital?

8. Do you have a cognitive bias checklist in place to minimize the risk of biased or faulty thinking when evaluating an investment?

9. Do you have a watchlist? Is it up to date? Is it a hodgepodge, or does it contain actionable stocks with pre-determined buy prices?

10. Do you write down your investment thesis, prior to pulling the trigger on a new investment?

11. How do you size a new positions? How many stocks do you hold? Are you a focused investor (Glenn Greenberg) or widely diversified (Walter Schloss)? Why?

12. Do you scale into new positions? Do you buy more when a stock goes down? Do you do this haphazardly or have you thought it through?

13. Do you hold cash and, if so, how much? How did you determine the amount? Does your hurdle rate go up as you cash holdings go down, i.e. do you become increasingly selective as your cash goes, for example, under 20%?

14. How do you monitor your existing holdings? How are you organized to stay on top of your investments? How could you improve?

15. Do you listen to conference calls and read the Q’s? Do you look for disconfirming evidence that challenges your thesis?

16. Have you defined your sell criteria? If you are a long-term investor, is there an over-valuation level at which you would sell? Do you figure it out ahead of time and mark it down?

17. Do you trade around positions – making partial sells and buys as your stocks become over or undersold? Why or why not?

18. Do you review your past mistakes? Do you record your lessons in a form that you can review and learn from?

19. Do you have a time when you regularly review your investment process – all of the above – and make a plan to improve it?

These questions are not exhaustive, nor are they meant to be. They are, however, more than sufficient to get you thinking about your own process and how to make it better. This is the path to beating the market.

One important element of the scientific method is having a properly constructed hypothesis. One of the essential characteristics of a good hypothesis is that it can be refuted or contradicted by an observation or physical experiment. Scientists call this characteristic falsifiability.

Likewise, one indispensible component of a market-beating investment process is being able to know if you made a mistake. Taking a page from science, we could call this characteristic “mistakability”. A good investing thesis is one that at some point in the future – as result of study and observation – you will be able to know if you were mistaken about, or not.

Speculating per se does not possess this quality. It often relies on nothing more that the notion that something is going up or down and that it will continue to do so. If it does not work out, it is insufficient – at least by the standard I am suggesting – to assert that you made a mistake because it stopped doing so. This is circular logic.

True mistakability is a substantive, positive, assertion grounded in logic and fact. “I think Microsoft’s current software royalties will continue to grow at five to seven percent over the next ten years and that its core software franchise is well protected by a strong moat grounded in high-switching costs and network effects.

If you do not have a clear, written investment thesis for each holding, each of which exhibits mistakability, you may be fooling yourself. If you manage money for others and an investment does not work out, you owe it to your investors to be able to provide a clear explanation of why you invested and what went wrong.

At the USC Law Commencement Speech in 2007, Charlie Munger praised Charles Darwin as a model of rational, objective thought, particularly his habit of trying to consciously overcome first-conclusion bias. This is one of the many forms of over-confidence bias that can be damaging to your wealth.

Munger stated that Darwin, “tried to disconfirm his ideas as soon as he got’em. He quickly put down in his notebook anything that disconfirmed a much-loved idea. He especially sought out such things.”

Following Darwin and Munger, we too should seek out that which disconfirms our own investment theses. Put simply, you should try to kill our own ideas. It is far too easy to fall in love with a stock and then let your own rose-colored glasses glibly filter away anything negative about the business. Of course, this is delusional: the market does not care if you like a stock and reality will ultimately have its way.

This type of disconfirming thinking was on full display at the 4th Annual Pershing Square Challenge, in which Columbia Business School students compete for a $100,000 prize in an American-Idol like stock picking contest.

One of the finalist teams pitched Aeropostale (ARO). They argued that Aeropostale is a best-in-class retailer which earns consistently high returns on equity. They highlighted the company’s multi-year same-store sales growth, and growth opportunities coming from international expansion, e-commerce sales, and P.S. from Aeropostale, a new concept which targets pre-teens. Also, they liked Aeropostale’s valuation – the stock was then in the mid 20’s – because they thought it gave no credit for Aeropostale’s growth prospects and that the company’s unlevered balance sheet provided an attractive target to leveraged buyout firms.

The Aeropostale team received a respectful grilling from the judges, which comprised a cadre of value-oriented hedge fund heavyweights led by Bill Ackman. The hedge fund judges did not appear overly taken with the team’s thesis. The concerns the judges raised, which were summarized at the end of the presentation by Ackman, provides a text-book example of the types of things you should be looking for when you seek disconfirming evidence. Of course, it goes without saying that raising a concern is not tantamount to proving that it will come to pass, but the process of raising objections and dealing with them is critically important in reducing mistakes and generating market-beating performance. If you do this religiously, you will have a leg up on all your competitors and counter-parties who do not.

Returning to the Aeropostale pitch, here is Ackman’s summary of the disconfirming concerns.

1. Aeropostale does not do anything proprietary; in other words, they do not have a moat. They piggyback off the intellectual property of other teen retailers such as Abercrombie & Fitch.

3. The growth opportunity is overstated. Aeropostale has already saturated the United States. In fact, Ackman questioned whether the total number of U.S. stores already exceeds the number of quality U.S. malls.

4. There is upward rent pressure and Aeropostale is susceptible to negative leverage if margins compress, given its fixed costs.

5. The market is used to strong same-store sales growth and could re-adjust Aeropostale’s multiple downward if the business generated negative numbers. [Note: the stock subsequently sold off to under $10 a share on poor same-store sales, among other factors, and has since rebounded to $16 per share.]

The lesson here is to look for disconfirming evidence, write it down (given the brain’s seemingly unlimited capacity to rationalize away this type of information), and take the time to give it serious thought before going forward.

For many years, Warren Buffett’s stated goal was to increase the intrinsic value of Berkshire Hathaway by 15% per annum. By doing this, investors could expect Berkshire’s value – and, with time, its stock price – to double every five years. (In the Berkshire Owner’s Manual, Buffett candidly states that this is the upper limit of what investors should expect today given Berkshire’s massive amount of capital and the difficulty for any large business to compound intrinsic value at 15%.) Prem Watsa’s stated goal at Fairfax Financial is to increase book value by 15% per year.

Finding stocks that will double in five years is, I believe, an aggressive but realistic objective for an active individual investor who develops the requisite skills and works hard at it. If you achieve this goal over the long term – regardless of whether your annual returns are lumpy along the way – you can expect to soundly beat the S&P 500. Your much smaller capital base is a distinct advantage vis-à-vis large investors such as Buffett or Watsa who need to deploy billions of dollars.

What you are essentially trying to do is to figure out what a business’s shares will be worth in five years and then to look to buy them at half of that today. How you get there will be some combination of growth in intrinsic value and buying shares at a discount to intrinsic value. One example is to find a company that can grow earnings at 15% for the next five to ten years and then buy it at fair value. You then sit tight as the stock price rises in tandem with earnings growth. Another approach is to find a stable, high quality business and buy it for 50% of its intrinsic value with the expectation that, over the subsequent five years, the market will re-price the security to reflect its intrinsic value. If it happens sooner, your rate of return is even higher. Finally, there is the combination approach where your double comes not only from growth in intrinsic value, but also the closing of a valuation gap.

One more thing: however you get to your double, you should always include a consideration of certainty. One way to think of it is that your outcome will be a function of your expected return and the certainty with which you will obtain it. Ideally you want investments where the expected mathematical annual return is 15% and the certainty with which you will obtain it is near 100%. You may want to consider changes in your portfolio if you can exchange your current holdings – after consideration of taxes, if any – for ones that offer a higher expected return or a higher certainty of obtaining generally the same return as an existing holding.

There are other frameworks for beating the market, but this is a good one. It is both conceptually simple and within reach. It goes without saying that compounding at this rate over long periods can generate real wealth.

Likewise, basketball is simple but not easy. All you need to do is put a ball with a 9″ diameter into a hole with a 17″ diameter. Simple, right? That is until you have a great athlete in your face playing defense along with the pressure of performing when it really matters.

Investing is simple because all you need to do is buy a meaningful amount of a business that is selling for less that it is worth and hold on until the market recognizes its miscalculation. This is not easy because it requires a rational framework that fully respects both the intelligence and skill of your counter parties and the high degree of efficiency often present in markets, along with the emotional discipline to act rationally in the face of fear and greed.

One common error of investors is to make things too complicated. One embodiment of this is the complex financial models found in analysts’ spreadsheets. Without a grasp of the right questions and a good dollop of wisdom, these can often obfuscate as much as enlighten. There is a reason Buffett does not even use a calculator when valuing a company.

The key to being a great investor is knowing how to ask the right questions and then only investing when you can actually answer them with a high degree of certainty and conviction. You do not need to do this very often. In fact, it is probably not possible to do it very often.

When NBA rookie Derrick Williams worked out with Kobe Bryant over the summer, he asked Bryant what moves he should work on. Bryant told him it was not a question of having a lot of moves, but rather having a small number that he could actually execute and finish – that were unstoppable.

If you want to have that kind of success as an investor, spend your time figuring out the pivotal questions upon which your investing thesis is based. Eschew false precision and seek broad certitude.

Consider how Greenberg explained at Columbia how he decided to invest in Google. Greenberg admits that there is a lot that he does not know about Google. But he does know that people now spend 30% of their time online and that 10% of advertising is done online. He is willing to bet that over the next five to ten years the percentage of advertising done online will catch up with the percentage of people’s time spent online. He does not know exactly how it will play out, but he does believe that Google, with a 50% market share in online advertising, will get its fair share.

Focus on asking the right questions – the big, broad ones that really matter. If you get these right, the answers will shakeout out into the knowable and unknowable. If you focus on investing in the first camp and have the discipline to not overpay, you are well on your way to beating the market.

Most of us do not easily part with our money. We like to think of ourselves as shrewd. We want good, reliable information before making a purchase. Yet, something interesting often happens when we decide we want something – we change from a dispassionate rational shopper to falling in love with the object we desire – particularly when there is a real or perceived scarcity factor involved. Our rationality can quickly give way to anxiety, greed and impetuousness. It is as if the brain short circuits and goes directly for the kill, as other more balanced considerations fade into the background.

It was against the backdrop of this reality that Ben Graham formulated his wise and proven approach to investing, he himself having been almost wiped out by the 1929 crash. At its heart, Graham’s approach to investing is very simple and rests on a relatively small number of timeless principles. Buffett has traditionally singled out two: The Mr. Market parable which crystallizes the proper way to think about market prices and the Margin of Safety which both minimizes the possibility of permanent loss of capital and provides a hedge against human error and ignorance.

I would argue that an equally important principle is encapsulated in Grahams definition of investing itself as found in The Intelligent Investor, to wit, “An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” [Emphasis added]

Now, it is said that the road to hell is paved with good intentions. No value investor worth his salt would not agree that he should do his homework before pulling the trigger on a new investment. The problem comes when that dispassionate analysis gives way to the greedy impulsiveness described above.

“This one is going to get away.” “Its about to run up in price.” “So and so has already established a large position.” “I’ll initiate with a starter position.” Man’s capacity to rationalize is limitless, and his good intentions provide flimsy guardrails. None of these reasons even remotely equates to “thorough analysis”.

Thorough analysis is part of the margin of safety. It reduces mistakes. It squeezes out luck and injects skill into the equation. It fosters conviction – the kind that really counts when prices inevitably move against you in the short or medium term.

Do not skip thorough analysis. If you got away with it in the past, consider yourself lucky and resolve never to do it again. (The funny things about markets is that they can sometimes teach the wrong lessons.) Chances are you can look back over your investing career and identify several investments where you skipped this step and lost money. In investing, just playing good defense and not having periodic material losses will go a long way to improving your long-term compounding.

Think of thorough analysis as an intergal part of investing. Resolve to not commit capital if you do not do this. Consider selling positions where you skipped the thorough analysis, or at least roll up your sleeves now and do it for all your holdings. Most skip this at their own peril and, if you do it religiously, it will go a long way towards identifying market-beating investments.

The author of this blog is NOT an investment, trading, legal, or tax advisor, and none of the information available through this blog is intended to provide tax, legal, investment or trading advice. Nothing provided through these posts constitutes a solicitation of the purchase or sale of securities/futures.
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